Index Investment

And
Exchange Traded Funds
 Outline
The theory of index investment
The implication of the Portfolio Theory and CAPM
Types of indices
Price-weight, value-weight, equal-weight, and strategies
Index investment
Advantages versus disadvantages
Fully versus sampled indexed
Index fund management
Costs, cash management, and trading
Alternatives to Indexing
Exchange Traded Funds
Enhanced Index Funds
Case study—Vanguard
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Efficient Frontier with Many Securities
• If markets are efficient and investors are rational, what
portfolios should investors hold?
Efficient Portfolios – portfolios with the smallest possible
standard deviation for a given expected return

E(r) Efficient Frontier A

MV
Feasible Securities

C

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 The Market Portfolio

E(R)

M
E(RM) Capital Market Line

MV

Rf


0 M

Under the assumption of homogeneous investors

All investors will hold the tangency portfolio M
In a market equilibrium
The portfolio M becomes the market portfolio
Implication: Every investor should just hold the market portfolio!
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http://www.cnbc.com/2017/04/16/vanguard-is-growing-faster-than-everybody-else-combined.html

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 Indices
How can we construct the market portfolio?
Use indices as proxies
What are they?
An indicator of average security prices
Why do we need them?
Tracking market returns
Benchmarking fund manager performance
Bases for derivatives, e.g., index options
Of course, investing
Factors affecting an index
Representative?
Weighting of components?

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 Types of Indexes
Price-weighted Average
Example: DJIA (30 stocks)
Value-weighted Average
Example 1: S&P (500 stocks, 100 stocks)
Example 2: NASDAQ (~3,000 stocks)
Example 3: NYSE (~3,000 stocks)
Example 4: Wilshire 5000 (~7,000 stocks)
Equally Weighted Index
Example: Value Line Index (~1,700 stocks)
Hybrid indices
Sector or class double weighted

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 Price Weighting
This method involves two steps:
First, sum the prices of the stocks that are included in the
index
Second, divide this sum by the “divisor”
Why is this method called price weighting?
Each stock return is weighted by the respective stock
price weight
Why do we need a “divisor”?
In order to ensure the continuity of the index
How would you construct a price-weighted
portfolio?
Holding the same number shares for each asset
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An Example – Adjusting Divisor

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 Price Weighting – the Dow
The Dow Jones Industrial Average (DJIA)
One of the most widely used indices
Price weighted average of 30 stocks that are generally leaders in their
industry
On October 13, 2011, the divisor was equal to 0.13212954
On October 1, 2013, the divisor was equal to 0.130216081
As of March 18, 2015: divisor=0.14985889030177
Note that the DJIA does not consider dividends
What is the meaning of the return in the DJIA?
It is the capital gain return on a portfolio that includes an equal
amount of shares of the 30 stocks in the DJIA
Besides the DJIA the Dow Jones & Company also computes
Dow Jones Transportation Average (20)
Dow Jones Utility Average (15)
Dow Jones Composite Average (65)

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History of the Dow

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Value (or Capitalization) Weighting

This method involves three steps:

1) Compute the index’s market values (MVt)
Calculate individual stocks’ market value (capitalization) from
multiplying price by the number of shares outstanding
Adding up individual stocks’ market value in the index
2) Adjust the divisor t if the composition changes
3) Finally, use the following formula to compute the new index
level: It = MVt/ t
Why is this method called value weighting?
Stock returns are weighted by the stock market value weights
in the total aggregate market value (of the stocks in the index
How would you construct a value-weighted portfolio?
Wealth is distributed according to market cap

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An Example – Adjusting Divisor

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 S&P 500 and Other Indices

The Standard and Poor’s 500 (S&P 500) is also a

widely used index
It is a value weighted average of 500 large stocks
representing all major industries
The S&P 500 does not reflect cumulative dividends
What is the meaning of the return in the S&P 500?
It is the capital gain return on a value-weighted portfolio that
includes shares of the 500 stocks
Other popular indices for measuring group
performance
S&P 400: mid caps
S&P 600: small caps

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 Equal Weighting

This method involves three steps:

1) Compute each stock’s price ratio between time t’s and time (t-1)’s
prices
2) Compute the average price ratio (ARt)
Use arithmetic average or geometric average
3) Finally, use the following formula: It = It-1*ARt
Why is this method called equal weighting?
Stock returns are equally weighted in the total aggregate investment
value (of the stocks in the index)
Unlike price or value weighted indices, equally weighted
indices do not correspond to buy-and-hold portfolio strategy
Examples: Value Line Composite Arithmetic Index and
Value Line Composite Geometric Index (not exactly)
How would you construct an equal-weighted portfolio?
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 Index Investment
History
Indexing was initially made available to institutional
investors in 1971
Individual investors were able to play indexing when
Vanguard 500 Index fund made its debut in 1976
The total asset under indexing in 2014 are over $1.8
trillion
The total market cap of mutual fund is $14 trillion
There are 53 million households own mutual funds
One third of which own index funds
Types of index funds
Equity, bond, sector, international
ETF
The total market cap of ETF is $1.4 trillion in 2014
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The Advantages of Index Investing

Tracking the market trends

If we believe that the economy will grow, the overall equity
market will grow along the way
Need to invest in a long-term
Diversification
Reduce idiosyncratic risk
Low cost investment
Zero stock selection costs
No need to do research
Less transactions costs
The composition of a index does not change very often
Tax efficiency
Low turnover
Less realized capital gains
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Possible Drawbacks of Index Investing

Weighting bias
Most indices, such as S&P500, Wilshire 5000, use value-
weight in constructing index portfolios
This is a correct way to capture the image of the market
Bias towards large firms
It will result in an increase in the volatility of investment
From an investment perspective, you are less diversified
Representation bias
May only represent a small number of firms, e.g. the Dow
Human factor, e.g. Apple in not in the Dow
A current focus
A large firm may not continue to grow
Eastman Kodak/Apple
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Innovation in the Indexing Industry

Module7B_5_PassiveStrategies.p
Module7B_5_PassiveStrategies.ppt
pt

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 Fully Indexed Fund

An index fund attempts to replicate a market index

It is relatively simple to create, once the index to be
replicated has been identified
But not necessarily easy to maintain
Procedure:(For Value-Weight, e.g., S&P 500)
Identify the index to be replicated
Estimate the total market values of all firms in the index
Create a market-value weighted portfolio of stocks in the
index
The percentage of wealth invested in each stock equals the
portfolio weight
This fund will replicate the index and is self correcting
It only needs to be adjusted when stocks enter or leave the
index
It corresponds to a buy-and-hold strategy
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 The Sampled Index Funds

Holding a limited number of stocks by sampling an index

The index contains too many stocks like the Wilshire 5000 or
it is too expensive to index the assets in a fund

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Expense Ratio of Mutual Funds

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 Index Fund Management
Index fund managers have three basic tools to replicate
benchmarks: futures, exchange-traded funds, and slices
A slice is a basket of stocks that is weighted identically to
the benchmark
It is created by computer models that calculate exactly how many
shares of each security are necessary to replicate the index
weighting
Futures contracts are used as a proxy for the entire index
Most mutual funds restrict the use of futures to a certain percentage
of their net assets
Fund managers may use futures contracts to equitize cash
when there isn't  sufficient cash available to buy a slice of stock
Index fund managers can also use exchange-traded funds
(ETFs)
ETFs have prospectus limitations that are usually more restrictive
than those for futures

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Tax Advantage of Index Funds

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 Exchange Traded Funds (ETF)

ETFs represent shares of ownership of a UIT

It can hold stocks, bonds, currencies or commodities
It is relatively new
S&P 500 depositary receipts (SPDRs) is the first U.S. ETFs
created by State Street Global Advisor in 1993
There are about 2,000 ETFs, totaling $4 trillion by the end
of 2018
ETF Index Fund
Trading During trading day At closing
Operating expenses Low Vary
Mini. investment No Yes
Tax-efficient Yes Yes, next to ETF
Style Passive Passive

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US Total ETF Assets

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 ETF Structure and Creation

The creation
Starts with a sponsor, ETF manager, who files a plan (prospectus) with SEC
Sponsor forms an agreement with an authorized participant
APs are US registered, self-clearing broker dealers who meet certain criteria and sign a
participant agreement with a particular ETF sponsor or distributor to become authorized
participants of the fund.
Authorized participant borrows shares of stocks from institution to form a
portfolio
Shares are kept with a trust (custodial bank) and the trust forms creation units
of ETF and sends back to authorized participant
Creation units are bundles of stock varying from 10,000 to 600,000 shares, but
usually 50,000
Authorized participant sell shares of ETF in the open market

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 ETF Redemption

The Redemption
Sell shares on the open market
Gather enough shares to form a creation unit and then
exchange the creation unit for the underlying securities
Only available to institutional investors
More on difference
Pricing
The price of an ETF share is continuously determined
Index funds are “forward priced”
Taxation
ETF: no tax implication because of exchanging shares
Index fund: redemption has implication for all investors

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 Enhanced Indexing

Synthetic enhancement strategies

Using the whole range of derivatives – futures, options and
swaps- that may be available at any time on an index, you
look for mispricing that you can use to replicate the index
and generate additional returns
Stock-based enhancement strategies
Adopting a more conventional active strategy using either
stock selection or allocation to generate the excess returns
Quantitative enhancement strategies
Using the mean-variance framework to determine the
optimal portfolio in terms of the trade-off between risk and
return

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The next step in the evolution of indexing

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Case: Vanguard Target Retirement Funds
Background: The Vanguard Group is the most
successful passive mutual fund complex, established on
the idea of efficient markets and using indexing as a tool
Objective: How can Vanguard continue to grow by
offering the life-cycle funds?
Questions:
Discuss and explain the relationship between the
development of the index fund industry and the modern
portfolio theory.
Why does Vanguard promote the life-cycle funds? Are they
successful in their effort?
What are the risks in offering the new product?
Discuss and explain the relative merit (and disadvantage) of
Vanguard’s business model as compared to the rest of the
investment management industry.

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